Speech by SEC Commissioner:
Remarks before the SIFMA Risk Management Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
New York, New York
June 27, 2007
Good afternoon. It is always a pleasure to speak at SIFMA Risk Management conferences — the work you do managing the operational, credit, and market risk exposures of your firms is critical to their success and the stability of the broader financial markets. Given the pace at which these markets innovate and thus pose new challenges to people in your position, I appreciate your taking the time to be here today. Before I begin, I must convey that the views I express are my personal views and not those of the Securities and Exchange Commission or other individual members of the Commission or its staff.1
As you know, the Commission currently supervises five of the major U.S. securities firms on a consolidated, or group-wide, basis. For these firms, referred to as consolidated supervised entities or "CSEs," the Commission oversees not only the U.S. registered broker-dealer, but also the holding company and all affiliates on a consolidated basis. These affiliates include other regulated entities, such as foreign-registered broker-dealers and banks, as well as unregulated entities such as over-the-counter derivatives dealers. The CSE program is designed to be broadly consistent with Federal Reserve oversight of bank holding companies. Indeed, the Commission's CSE program has been recognized as "equivalent" to that of other internationally recognized supervisors, including the U.S. Federal Reserve, for purposes of the E.U.'s Financial Conglomerates Directive.
This prudential regime is crafted to allow the Commission to monitor for, and act quickly in response to, financial or operational weakness in a CSE holding company or its unregulated affiliates that might place regulated entities, including U.S. and foreign-registered banks and broker-dealers, or the broader financial system at risk. Certainly risk managers and regulators alike recall how the bankruptcy of the Drexel Burnham Lambert Group and the consequent liquidation of its broker-dealer affiliate in 1990 highlighted the risk that exists when regulated entities become affiliated with more and more complex holding company structures. While maintaining broad consistency with Federal Reserve holding company oversight, the CSE program is tailored to reflect two fundamental differences between investment bank and commercial bank holding companies: First, the CSE regime reflects the reliance of securities firms on mark-to-market accounting as a critical risk and governance control. Second, the design of the CSE regime reflects the importance of maintaining adequate liquidity in all market environments for holding companies that do not have access to an external liquidity provider.
The CSE program is intended to be flexible and not prescriptive, and thus differs from the Commission's rules-based regulatory programs. This approach works well, I believe, in the risk management context and dovetails with the Commission's compliance program for broker-dealers. Nonetheless, managing the risks posed by the rapid growth in both the size and complexity of products and activities by CSE firms has been a challenge for risk managers and for their regulatory supervisors also. At the same time, we have had to grapple with the implementation of the Basel II Standard by the CSE firms. The Basel II standard for capital requirements permits banks to use proprietary models developed by each institution for risk management purposes to compute capital charges. The revised standard aims to assess capital in a manner that reflects the underlying economic risks born by institutions while facilitating comparison across institutions by creditors, investors and regulators.
But there is clearly a tension in seeking to accomplish these goals all at once. As supervisors, we must balance building a capital computation based on banks' internal models with maintaining consistency across these internationally active institutions that have fundamentally different business models. If we were to require that banks compute capital in a manner consistent with the way that they manage risks and also demand that all banks compute capital using equivalent methods, we would be essentially mandating the internal risk management systems of the firms. In our view, imposing consistency in risk management practices through the capital computation would turn the Basel principle on its head in a way that is detrimental to good governance. However, as supervisors, we cannot tolerate gross disparities in the way that capital is computed across institutions.
I'd like to discuss the Commission's trading book review as an example of how we address these challenges in the CSE program. The Basel Standard basically views risk positions as residing in either the "banking book" or the "trading book." Banking book positions look like traditional portfolio lending, with assets typically held to maturity and subject to accrual accounting. Consequently, the capital requirement is reflective of the longer holding period during which an institution is effectively "tied to the mast." Trading book positions have a more market risk flavor. These products are marked-to-market and actively hedged by the firm. In many instances they will not be held for an extended period of time by the firm, and in all instances they must be either easily sold or readily hedged. The capital charges for such positions reflect that institutions have more options than in the case of banking book positions to shed the positions, or the risk of the positions. The overwhelming bulk of the capital charges at commercial banks typically arise from the banking book. By contrast at securities firms, the trading book is substantial.
As a result, we are particularly concerned that the trading book charges specified under the Basel Standard may sometimes be inadequate. This is because the trading book charges are computed according to the 1996 Market Risk Amendment to Basel I, and are based solely upon value-at-risk techniques. At the time of this amendment to Basel I, a far smaller range of positions met the trading book tests. And these were primarily equity, investment grade debt and fixed income and foreign exchange derivatives, which are highly liquid and relatively easy to deal within a VaR framework. Today risks related to the liquidity and complexity of products held by CSE firms and eligible for trading book treatment are not always measured well by VaR.
We fully believe in an expansive view of the trading book, with a wide range of positions eligible for inclusion. The key tests for eligibility are trading intent, mark-to-market valuation, and the ability to rapidly sell or hedge a position. An increasing number and range of positions meet these tests, as new instruments and markets emerge that permit more active hedging of a greater range of positions, and existing markets grow in liquidity. The basic principle of Basel is that regulatory capital should be based upon an institution's internal risk management processes. Given the importance of mark-to-market discipline as a risk management and governance control at the CSE firms, we believe that a wide variety of positions should be eligible for trading book treatment. For instance, securitizations and leveraged loans are now considered in the trading book (which would not have been the case 10 years ago, when these markets were far less liquid and the range of potential hedging instruments was far more limited). Certainly forcing positions to be held in the banking book makes no sense where these positions are actively traded, marked-to-market, and hedged.
At the same time, we must acknowledge that taking an expansive view of the trading book will include a variety of products and exposures exhibiting risks that may not be measured well by VaR. These include a range of securitized products and certain loan assets. In addition, a variety of market neutral trading strategies, including risk arbitrage, generally send poor VaR signals. All of these positions involve exposure to various event risks that VaR measures are not well-designed to capture.
We use the flexibility in Basel II, as well as in our own Commission rules, to take a comprehensive approach to the trading book. By this, I mean that we have taken an expansive view of the positions eligible for inclusion in the trading book, where an institution can demonstrate trading intent, a strong mark-to-market process, and sufficient market liquidity. The Commission staff has also worked with the firms to identify material risks in the trading book that are not fully captured in VaR, and have developed general approaches to appropriately capitalize those risks in a manner consistent with the way that they are managed by the firms. In fact, SIFMA has been very helpful in organizing an ad hoc committee of senior risk managers from the CSE firms who recently produced a paper that explains how a variety of risks that are found in an expansive trading book but not well-captured in VaR can be fit into a single conceptual framework.
I am pleased to say that the CSE firms have embraced this approach, at least relative to the alternative — the continued broad use of standardized charges in the trading book. When we first implemented Basel II, in order to allow an expansive view of trading book eligibility while assuring sufficient capital, we required that the firms take standardized charges, known as Reg Y charges, after the relevant Fed rule, on all non-investment grade trading book positions. While this resulted in large amounts of capital, CSE firms argued that the charges were uneconomic, and could even provide perverse incentives. For example, purchasing a credit derivative that hedged a bond could actually increase the overall capital requirements, even though the credit derivative reduced economic risk. But these substantial Reg Y charges, in some sense, compensated for other parts of the trading book where the model-based charges allowed were clearly inadequate.
We are now in the process of conducting a "holistic" trading book review at the CSE firms. Part of that process entails moving away from the Reg Y charges that all parties agree are high and, in some cases, may distort incentives. But, at the same time, we need to be sure that we have identified all the risks in the expansive trading book, and have ensured how all material risks, whether conducive to measurement through VaR or not, impact the capital computation. Our aim, at the end of this holistic review, is a trading book capital computation with an aggregate amount of capital that provides sufficient cushion against losses without distorting the incentives faced by trading desks. In other words, we want the capital charges to reflect the underlying economic risks of various positions, and the way in which the risk of those positions are managed internally by the firms. We look forward to continuing to work with the risk managers at the CSE firms in completing this formidable task.
I'd like to speak about leveraged financing, and in particular event-driven lending, which has grown substantially over the last few years and is now a primary driver of corporate lending exposure at the U.S. investment banks as well as their commercial bank counterparts. For example, U.S. new issue leveraged loan volume was approximately $480 billion in 2006 compared to $295 billion in 2005.2 Event-driven lending consists primarily of leveraged bank loans made to non-investment grade counterparties, typically for acquisitions, LBOs, and recapitalizations. Leveraged loan facilities generally consist of a combination of revolvers, term loans, and/or bridge loans. Dividing the financing into these various components allows the originating institution to match the preferences of pension plans, hedge funds, and other institutional investors.
Investment banks now routinely deal with initial commitments to non-investment grade counterparties measuring in the tens of billions. The size of some of these commitments is really amazing, particularly given that only several years ago a commitment of several billion was considered outsized. Nonetheless, these large commitments provide the critical financing that allow ever larger acquisitions, leveraged buy outs, and recapitalizations. Unlike other corporate lending, where investment banks intend to hold and actively hedge the commitments, these initial, event-driven, commitments are contemplated with the understanding that the exposure be syndicated, or "sold," to counterparties fairly quickly.
With this brief background, I'd like to highlight some areas of current concern for regulators related to event lending, in addition to just the rather amazing size of many transactions. Given that the primary risk management tool for the originating bank is syndication of the exposure, the central risk of these transactions lies in the bank's potential inability to irreversibly and rapidly exit its sizable exposure through syndication. As a supervisor, there are a number of scenarios that we consider in this regard.
First, the leveraged loan market has evolved in a number of ways over the past several years. As I noted previously, commitments have become larger. At the same time, the depth of the market and its price transparency have undeniably increased. But we have also seen consistent pressure on terms, including covenants. Covenant-lite and similar structures, which limit lenders' ability to intervene quickly if a borrower displays financial weakness, have gained widespread acceptance in the market despite occasional pushback that has been visible against the most aggressive variants. This easing of terms may not have great consequences so long as credit spreads remain tight and liquidity in the leveraged loan market remains high. But, to the extent that covenants provide protection to lenders who cannot easily trade away their exposure, the movement toward covenant-lite structures could have consequences if the new liquidity in traded loans ebbs during a market stress period and the holders of the positions are left with limited ability to shed exposure or influence the behavior of borrowers.
We also are concerned about the liquidity resources of some of the new players in the traded loan market. Increasingly, hedge funds purchase unfunded loan commitments syndicated by commercial and investment banks. Often, there are extended settlement periods for these sales during which no collateral is posted. So long as the commitments remain unfunded, the risk associated with these positions is limited to the mark-to-market change in the value of the commitment based on credit spread movements. But if a commitment should be drawn, for instance, because of deterioration in credit market conditions during an acquisition, there is not only credit risk but also liquidity risk. In such an environment, the ability and willingness of a hedge fund to produce say several hundred million dollars to fund a commitment is less likely. Again, we can well envision in such situations that some would expect the originating institutions, which had syndicated the exposure to the fund, in some manner or another to step up and fund the commitment. Whether they would or not is open to question. But either course of action would raise serious concerns.
In addition to more traditional institutional investors and hedge funds, sponsors of structured credit vehicles known as CLOs or collateralized loan obligations have increased their participation in the leveraged loan market. In fact, as the size of commitments has risen and covenants have become weaker, the so-called "structured bid," or appetite for loan assets to securitize through CLO structures, has been cited as a key driver of the market. By and large, the dispersion of risk more broadly, as is accomplished through structured products, seems a good thing. But, just as in the case of hedge funds purchasing commitments, the finality and completeness of the risk transfer using CLOs is not certain. Securitization of course involves pooling non-investment grade assets and, through diversification, producing some investment grade securities from the pool. But there are also byproducts, including some relatively risky tranches, colloquially called "toxic waste," that concentrates credit exposure. Here again hedge funds have emerged as important purchasers of these instruments. By buying these equity interests, the funds potentially both earn high returns for their investors and at the same time make it possible for the securitization model to successfully move leveraged loans off banks' balance sheets and into CLO structures.
So long as the funds purchasing the equity interests, akin to the residuals from mortgage securitizations, do so with cash, the risk transfer is clearly complete and irreversible. But there are some gray areas. For example, a bank may sell an equity interest to a hedge fund but then finance the position through a repo-like secured financing transaction at a specified haircut. Or a bank may retain some risk and then lay that risk exposure off to a hedge fund by using a total return swap. In both examples, the risk transfer may be less complete. In the first instance, a decline in value in the financed instrument may leave the dealer with insufficient or illiquid collateral. In the second instance, depending on the degree to which the total return swap is collateralized, the bank may have merely transformed market risk into credit risk to a non-investment grade hedge fund counterparty.
Other than worrying, how should we in the regulatory community respond to the growing size and complexity of leveraged lending transactions and related markets? One partial solution that I discussed earlier is capital. The leveraged lending business is a place where implementing regulatory capital standards that assessed in a risk sensitive manner remains a challenge. One can read the Basel Standard carefully and repeatedly and not find any discernable reference to the business that I've just described. Thus we have worked hard, and continue to work hard, to apply the basic principles that I've discussed today, such as linking capital computations to internal risk management practices, in the context of leveraged lending exposures at the CSE firms. Fortunately, many of you in this room and your colleagues have worked with us in this endeavor.
Before concluding, I'd like to briefly discuss the recent events at a hedge fund managed by Bear Stearns Asset Management that has been covered in the financial press these last few weeks. While we obviously will continue to follow further developments closely, I think there are several issues already highlighted by these events that regulatory supervisors and risk managers alike will need to consider.
Certain basic facts by now are generally understood from media accounts. One hedge fund managed by Bear Stearns Asset Management called Bear Stearns High Grade Credit Strategies Enchanced Leverage Fund, after having losses of approximately 20 percent thus far this year, faced significant liquidity pressures from investor redemptions and margin calls. By way of background, the fund invests in investment-grade structured credit products, including derivatives referencing market indices and collateralized debt obligations (CDOs) — a number of which are tied to the performance of pools of subprime mortgage loans. By their very nature, many of the products embed significant leverage and the fund used additional bank lending to increase leverage as well.
The financial press described what the fund's creditors, a group that includes several of the CSE firms as well as other major dealers, were considering in response. Among the options were either to collectively provide some forbearance, and by doing so would provide the fund an opportunity to liquidate in an orderly manner its remaining positions, or to individually invoke default provisions that would permit the immediate seizure and liquidation of collateral. This latter alternative potentially could trigger a broad dislocation in the market for securities tied to subprime mortgages. The fund also proposed a standstill provision in a global creditor agreement under which all creditors would not call for margin for some period of time.
Regardless of what steps creditors determine to take, I think there are several issues raised by these events that should focus the attention of, and stimulate discussion between, the industry and regulators. First, the potential incorporation in creditors' agreements of standstill provisions as well as less formal forms of forbearance by creditors raises some concern. If we see creditors refraining from immediate exercise of their liquidation rights when hedge funds face liquidity difficulties, regulators will naturally question the adequacy of haircuts, particularly for less liquid positions of the sort in the High Grade Credit Strategies Enhanced portfolio. Setting haircuts to protect a firm for a 10-day period, for example, may not be adequate if dealers systematically hesitate to exercise their rights to make margin calls or liquidate collateral.
Without a doubt the events at Bear Stearns Asset Management highlight both the risks investors take when they buy illiquid and hard-to-value securities and the trigger-effect when one creditor sells substantial amounts of illiquid assets into the market (prompting others to follow). Recent events should also focus attention on the challenges of valuing portfolios such as that run by High Grade Credit Strategies Enhanced, and the importance of those valuations to the management of credit exposures. Valuation processes are critical to the management of secured credit exposures to hedge funds, as haircuts are computed with reference to mark-to-market valuations. Further, margin calls are hinged on changes in mark-to-market valuation. However, prompt payment by a counterparty occurs only with acceptance of the financing dealer's mark. The experiences these past several weeks suggest that added investment in infrastructure and personnel are necessary to quickly and repeatedly revalue portfolios of less liquid positions during periods of market stress. Further, greater transparency concerning valuation practices may be warranted.
A third issue that merits further attention in the wake of the liquidity problems at High Grade Credit Strategies Enhanced involves the risk transfer issue I previously alluded to in the context of collateralized loan obligations. Just as collateralized loan obligations are used to distribute leveraged loan exposure across the financial markets, similar securitization vehicles are used to spread the risk of subprime mortgages. These types of instruments were heavily represented in the portfolio of High Grade Credit Strategies Enhanced. A number of banks and securities firms appear to have provided financing in the sales of these securitized products to hedge funds. Without adequate collateral, such financing would not be clean risk transfers, and thus should raise serious risk management and supervisory concerns for any banks and securities firms that may engage in these financing arrangements.
These recent events will undoubtedly hold lessons for risk managers at large financial institutions as well as those of us in the regulatory community. It is critical that we collectively reflect on these events and use these experiences to improve risk management and regulatory practices in a manner that increases the resiliency of financial markets without diminishing their vitality. I look forward to working with you and your colleagues in achieving this goal.